Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Securities Regulation, June 2008
Following an issue-oriented review of general compliance with National Instrument 81-106 - Investment Fund Continuous Disclosure (NI 81-106), the Ontario Securities Commission (OSC) has recently published Staff Notice 81-709 – Report on Staff's Continuous Disclosure Review of Investment Funds (2008) (the Notice). The Notice summarizes the findings and comments arising from the continuous disclosure review program conducted by Staff at the Investment Funds Branch of the OSC.
Aim — The OSC has stated that the aim of the Notice is to assist preparers of financial statements and management reports of fund performance (MRFP) in improving their future continuous disclosure. Although the findings in the Notice are mainly based on the review of disclosure of conventional mutual funds, OSC Staff is of the view that other investment funds such as closed-end and exchange-traded funds will also benefit from the Notice, and its guidance can be applied to their continuous disclosure.
Scope — OSC Staff's review focused on the continuous disclosure requirements applicable to conventional mutual funds relating to financial statements and MRFPs, quarterly portfolio disclosure, annual information forms and proxy voting records. The review predominantly covered financial year-ends in 2005 and 2006, but also captured some periods ending in 2007. OSC Staff reviewed the public disclosure record including the fund manager's Web site and all prescribed regulatory filings on SEDAR and sent comment letters to fund managers who, in aggregate, manage approximately 45% of the industry's assets under management.
Findings — OSC Staff noted several areas for improvement in terms of the quality of management's discussion, overall presentation and ongoing regulatory compliance. These areas include:
1. Quality of the discussion
Results of operations. Management's discussion of the investment fund's activities in the results of operations section should be more thorough and analyze and explain the nature of and reasons for changes in the fund.
OSC Staff found that approximately 40% of investment funds selected had financial statements that revealed significant changes in the fund which were not discussed in the results of operations section of the MRFP. OSC Staff was of the view that while discussion and analysis of every financial statement item may not be warranted, it expected the results of operations to focus on significant changes in the fund over the financial period and discuss the reasons for the changes. OSC Staff also found that 25% of investment funds disclosed significant changes but provided very little explanation or analysis.
Investment objective and strategies. A concise summary of the investment objective and strategies should be provided.
The review revealed that approximately 40% of fund managers should have provided a more concise summary of the investment objective and strategies of their investment funds in their MRFPs. OSC Staff was of the view that the disclosure must be a concise summary of the fundamental investment objective and strategies of the investment fund, and not merely copied from the fund's simplified prospectus.
Risks disclosure. More risk disclosure should be provided.
The review revealed that approximately 40% of fund managers did not provide an adequate discussion of risk. OSC Staff expected investment funds to provide a commentary on whether changes in the fund have had an impact on risk, along with a discussion of whether the suitability of the investment has changed from what was previously disclosed in the prospectus.
Annual compound returns — Broad-based index. Discussion of the relative performance of the investment fund as compared to a broad-based securities market index is required and cannot be replaced by a comparison to a narrow index or blended benchmark.
OSC Staff found that approximately 65% of fund managers did not compare the relative performance of an investment fund to a broad-based securities market index. OSC Staff reiterated that the discussion of the relative performance of an investment fund as compared to a broad-based securities market index is a requirement under Form 81-106F1 (the Form).
Annual compound returns — Discussion of relative performance. A more thorough discussion of why the investment fund under- or over-performed the index should be provided.
The review revealed that some investment funds should have provided a more thorough discussion of the relative performance of the investment fund as compared to the appropriate index. OSC Staff raised this issue with 75% of fund managers. OSC Staff was of the view that simply stating that the fund under- or over-performed relative to the index is a not suitable discussion. Instead, an explanation as to why the fund under- or over-performed relative to the index is expected. In addition, OSC Staff suggests that investment funds should consider using percentages and quantitative measures when discussing over- and under-weight portfolio allocations.
2. Overall presentation
Plain language. MRFPs should be written in plain language and avoid the use of jargon and technical language.
OSC Staff noted the use of jargon and technical language in the MRFP. The Notice states that investment funds should avoid jargon and communicate as simply and directly as possible.
Investment subgroups. Management should review the investment portfolio to determine if the most appropriate categories have been used when disclosing the summary of investment portfolio in the MRFP or quarterly portfolio disclosure, and whether the breakdown conveys the nature of the fund to readers.
OSC Staff was of the view that 17% of investment funds did not break down their investment portfolio into appropriate subgroups in the summary of investment portfolio, as required by the Form. OSC Staff also raised a comment if it felt that one subgroup was too generic and obvious.
Analytical review of financial statements. Manage-ment should perform an analytical review of the financial statements to ensure that all significant changes have been explained in the discussion of results of operations.
The review of financial statements revealed that significant changes were not addressed in management's discussion of results of operations in the MRFP. OSC Staff reminded investment funds that management should perform an analytical review of the financial statements to ensure that the management discussion of results of operations is complete and explains the significant changes of the fund or any unusual events.
Financial statement notes presentation. Notes to the financial statements are part of continuous disclosure and should not be convoluted with inapplicable information.
OSC Staff was of the view that it is not appropriate to create one set of notes for the whole fund group that is then attached to every set of financial statements without being modified for relevance. Additionally, OSC Staff noted that some of the investment funds did not address all the mandatory items which must be disclosed in the notes to the financial statements.
Web sites. Funds should ensure that their Web sites are organized in a way that makes information relatively easy to find.
OSC Staff found that approximately 40% of fund managers did not provide easily accessible links to continuous disclosure documents on their Web sites. It also found that in some cases excessive drilling down was required to reach documents. In these situations, OSC Staff raised comments asking that the fund manager consider adding more intuitive links to the fund's disclosure documents on their Web site.
SEDAR filings. Each MRFP should be filed on SEDAR only under the individual investment fund to which it pertains.
OSC Staff stated that each MRFP should be filed on SEDAR only under the individual investment fund to which it pertains (and not under a group profile). Further, if the financial statements and the accompanying notes for each fund are in a separate document, the relevant statements should only be filed under the fund to which they pertain.
3. Regulatory compliance
Commissions to related parties. Unless exemptive relief has been obtained, a monthly report must be filed when a fund pays a fee to a related company on a purchase or sale of portfolio securities.
OSC Staff noted that investment funds must file a monthly report when a fund pays a fee to a related company on a purchase or sale of portfolio securities, unless the fund has obtained exemptive relief from this requirement. In that regard, the Notice noted that some exemptive relief obtained in the past can no longer be relied upon as it was conditional on certain disclosure being provided in the statement of portfolio transactions, which is no longer required.
Financial highlights tables. The format specified in Form 81-106F1 for financial highlights and past performance is mandated.
The review found that approximately 40% of fund managers did not follow the set format of the financial highlights tables. OSC Staff was of the view that while an explanation can be added to the MRFP, additional lines cannot be included in the standard tables, and that the format of the financial highlights and past performance tables must be adhered to as mandated by the Form to ensure comparability between investment funds.
Management fees. Transparency around the composition of management fees is needed.
OSC Staff reminded investment funds that the purpose of the breakdown of the management fee is to explain to investors what services are provided in exchange for the management fee. If services cannot be individually itemized, the nature of those services should at least be described qualitatively. OSC Staff expected services to be expressed as an actual percentage of management fees, not as an estimate or a range, because the MRFP reports the prior period's activity, as well as that the management fees breakdown must disclose any differences between classes or series.
Annual compound returns. Certain information must be discussed including the performance of all series and changes in an index from the prior period. Discussion of past performance should be limited to the standard performance periods.
The review revealed that almost all investment funds with multiple series discussed the performance of only one series of the investment fund, typically the retail series. OSC Staff was of the view that at a minimum, investment funds must provide an explanation as to how the performance of all series differs from the specific series discussed.
OSC Staff was of the view that if an index is different from the one included in the most recently filed MRFP, the reasons for the change must be explained and the requirements relating to annual compound returns must be disclosed separately for both the new and former indices for the financial year. This means that both indices must appear in the annual compound returns table in the year of the change to help readers compare the fund's performance to the new and former indices.
OSC Staff was of the view that the discussion of past performance should not focus on non-standard performance periods such as the six-month return in the annual MRFP, or the quarterly return in the interim MRFP.
4. Other Matters
National Instrument 81-102 Mutual Funds (NI 81-102) compliance reports. The review revealed that some investment funds did not file the compliance report from their custodian to the securities regulatory authority within 30 days after the filing of the annual financial statements. In addition, some investment funds did not file the report describing compliance with Parts 9, 10 and 11 of NI 81-102, along with their auditor's compliance report, within the time limit as required by NI 81-102.
Annual notification of unitholders' rights to redemption. The Notice reminded investment funds that the requirements of NI 81-102 to provide all securityholders, at least annually, with a statement outlining rights with respect to redemptions may no longer be met by including it in the financial statements if those financial statements are not sent to every unitholder.
Next Steps – OSC Staff expects funds to consider the guidance in the Notice when reviewing their continuous disclosure records to ensure their disclosure documents comply with NI 81-106. OSC Staff has advised that in future situations where disclosure requirements are not met, OSC Staff will ask that the disclosure document be revised and refiled.
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